Hello, there! Welcome back. In this lecture we continue our discussion of preferences and utility functions that describe more realistically how people behave than the two dimensional mean various preferences we saw in the last course. Now note that these are not necessarily examples of irrational behavior, right? The expected utility framework still applies. But these type of preferences simply try to provide a richer model of how we make choices. So one such utility function is what we call habit utility. Habit utility is an example of utility functions that define preferences as dependent on, for example, an investor's environment. Specifically it's not the wealth or how the wealth is processed by the investor that matters, but it is the wealth relative to a reference point that matters, okay? So we humans can get used to a particular level of comfort or consumption very quickly, right? So for example suppose you're flying and you're stuck at the back of the plane, you're probably just happy to be traveling to some where exotic, right? The small seat, having your knees crammed up in front of you. Battling with your neighbor over the arm rest aren't so bad or bothersome, right? At least in most cases. Then you get upgraded to business class. Whoa, right? It's hard to ever go back, right? And then one day, you get really lucky and you get a first class upgrade on an international flight with the flat beds and unlimited champagne and everything, right? Now try flying economy next time. Forget it, right? It's like stepping back down to the cattle class, right? It really hurts. Even though you're really not any worse off than if you had never escaped the economy class, right? So it's habit, right? It's what you get used to, right? So the habit in habit utility is generally considered as the level of consumption or wealth you need to live a certain lifestyle, right? Whatever that may be. And as long as you are above that level, you're good. But as your wealth gets close to the habit level, right? You become much more risk averse, right? The investor gets much more risk averse and acts in a much more risk averse manner, right? In other words, with habit utility, risk aversion is endogenous, right? It changes with where you are relative to your habit, right? And habit itself can evolve over time too, right. For example your income could skyrocket, so you really don't ever have to go back to the economy class when you're flying, right? That becomes your habit shifts. Or you might lose your job and you're always stuck at the back of the plane, right? Or habits could change due to external factors, like macro factors. Or it could be internal factors, where it may depend on your upbringing or your family wealth, right? So what does habit imply for an investors asset allocation? Well habit utility suggest that we should consider a portfolio's returns in relation to the investor's habit, or what they're used to, right? In the case where she's close to that habit level, it's really, really scary time for her, right? She's going to want to invest in safe assets. But in good times, when her wealth level is far about the habit level, she will be much more tolerant and hold larger amounts of risky assets, okay. All right, so in this lecture we looked at another type of utility function, habit utility, which is one example of a relative utility functions, right? It is not your wealth, the level of your wealth that matters, it's your wealth relative to a reference point. In this case, what you're used to.
